1929

This writeup serves to outline the stock market crash of 1929, the causes of it, the long term ramifications of it, and what we can do to protect ourselves if/when such a situation occurs again in layman's terms, meaning no degree in economics needed. Also, some major conclusions about the modern world are drawn.

The Causes

During the late 1920s, many First World nations, particularly the United States, enjoyed a strong economic boom. During this period, many people were becoming urbanized and working at the factories that were cropping up, meeting the new needs of the populace by manufacturing canned goods, telephones, automobiles, and electric devices of all kinds. These "new" jobs gave people a disposable income that many of them did not have before, and they wanted to invest this money into something that would give them a strong return. Many families wanted the type of economic prosperity that they could pass to their children and all of the new opportunities gave them that chance.

With the large amount of disposable income floating around the economy, people were making many large purchases, buying cars, houses, and any number of electric goods such as radios and phonograph machines. This wave of purchasing built throughout the 1920s, causing a somewhat artificial inflating of company values in the mid to late 1920s.

However, by the late 1920s, many people had purchased a home, a car, and all the devices they could need, and their job still provided them with a great deal of money. So, what did they do with this money? They invested it. Naturally, they wanted a big return for their investment, so when they evaluated investment opportunities, time and time again they discovered that the stock market was providing ridiculous returns. Most companies were booming with the inflated income from the rampant consumerism at the time, and thus on paper it appeared as though the stock market was the place to quickly make some money.

Now, even then, Joe Average stock buyer couldn't afford to compete financially with the big boys, but the stock brokers could see that there was a lot of money to be made off of all of these new investors. So, the brokers offered these average investors a pretty sweet deal for both sides: buying on margin. Here's how it works: the new investor would put down 10% of an investment in a particular stock; let's say it's the Ford Motor Company. So, the investor goes to the stock broker and gives him $1,000. With this purchase, the stock buyer buys $10,000 worth of Ford on "margin," meaning that he has agreed to pay for this stock over the long haul either by cash or by other stocks at market value. Let's say that Ford is currently selling for $50 a share, so that means our investor friend has just purchased 200 shares of Ford. Now, our investor is required to start making monthly payments to his stockbroker at $100 a pop. This is fine, since our investor knows he won't be making the payments long. He makes 10 payments, adding up to another $1,000, which means he still owes $8,000 on the stocks bought on margin. Now, here's the sweet part: in these ten months, Ford's stock price has doubled to $100 a share. So, our investor friend sells 80 shares back to the market for $100 a piece, generating the $8,000 he needs to pay off his debt, and thus pocketing 120 shares of Ford for himself. How does the broker make money? The broker makes a charge on every transaction, so the broker is fine with the arrangement: more transaction, more money in his pocket, as well.

Now, those of you clever enough to put this together in your mind clearly realize that this is a pyramid scheme. The first investors will do just fine and make their profit from the new investors jumping in and buying stocks, pumping up their value. Eventually, though, you'll reach a saturation point where there are more sellers than buyers. When that happens, the stock price starts to drop, and then everyone wants out of the collapsing pyramid. This is exactly what happened in 1929.

There was another major factor that is often overlooked in American history classes, and that's the involvement of foreign nations in the stock market amplifying the problem. Many foreign governments were heavily involved in the market, too, trying to recoup their World War I losses. Great Britain was, in particular, heavily involved in the stock market, and it was an act by Great Britain that caused a wave of selling to hit Wall Street and trigger the financial earthquake.

During the 1920s, Britain desperately wanted to restore some of the pre World War I value to the British pound. To do this, in 1925, Britain allowed the pound to be directly exchanged with gold once again, placing Britain's currency back on a gold standard, as was common prior to the war. Given the long weakness of the British economy, however, the value of a British pound at the time was far less than a pound of gold, thus making the British pound far overvalued (note that this explanation is a bit simplified; the actual process was nightmarishly complex and would bore anyone other than an economist to sleep). To alleviate this, British investors sunk their money into the United States stock market. They knew that an economic boom was ongoing in the United States and this was a way to ensure that their investment wouldn't crash again.

Naturally, Britain would want her money back, and she cashed in her chips in September 1929, when Montagu Norman, the head of the British Bank, raised the British bank rate to 6.5%, which is insanely high (compare to the Federal Reserve discount rate as of August 2004, which stood at 1.25%), in order to encourage money for lending and for savings to move back to the now relatively stable Britain. Think of it this way: imagine if the place where your savings account resided paid 3% to 4% interest, and suddenly your buddy opened a bank up down the street and offered 6.5% interest on your account; you'd switch banks, wouldn't you? Well, it worked; money came tumbling out of the New York Stock Exchange and straight into British banks. This money exchange contributed just enough sells to cause a panic inside the giant pyramid that had been built on Wall Street.

Now, this type of thing happens on a regular basis, doesn't it? Everyone now is familiar with the dot bomb collapse of 2000 through 2002, which caused a collapse in the NASDAQ; for those a bit older, we can recall the collapse of 1987, which was seen as a sign of the failure of Reaganomics and tax break policies for the rich (it wasn't; Reaganomics caused the boom of the 1990s, but that's another topic). But there was one major factor that made these much less painful than the 1929 crash, and that was market controls. There are now a number of features in place to prevent this from happening with the devastation of 1929, and thus far, they've worked. We'll get back to these in a bit.

The Events

So, let's walk through 1929, event by event.

February 4, 1929: Montagu Norman raises the British bank rate to 5.5%. For the first time in a while, loans and investments in Britain returned a higher percentage yield than in the United States (at 5%), but not by much. The rates had been low in Britain to encourage small businesses to start up and get low interest rate loans; at this point, the government viewed the economy to be pretty stable there, so they were now trying to attract investors.

October 24, 1929: Black Thursday, in which the Dow dropped 12.8% of its value in a single day, and an all-time record of 12,894,650 shares changed hands ... remember, this was before any sort of electronic trading occurred. At noon, the market had lost 22.6% of its value, and a small riot occurred outside of the New York Stock Exchange as investors trying to get in fought with building guards and the NYPD. The afternoon saw a 9.8% rise in the market, and by the end of a short session on Saturday, the market regained its pre-Black Thursday value.

October 29, 1929: Black Tuesday, in which the Dow dropped 13.9% of its value, and it was not to recover. The market lost 37% of its value during the month of October 1929.

October 31, 1929: With the damage having been done, Montagu Norman lowered the British bank rate to 6%, anticipating a huge influx of cash into Britain.

The Ramifications

This stock market collapse triggered a huge chain of events that eventually led to World War II and thus directly into shaping our modern world.

First, countless people and governments lost most of their investment money directly from the stock market implosion. Most first world nations had large sums invested in the stock market and when the implosion of October happened, much of their money evaporated. Without this money, many governments could not afford to maintain many federal services; national banks collapsed, services disappeared, and a domino effect occurred, dragging down entities that relied on these banks and services.

Second, with the bubble bursting, there wasn't money left for other investments. Britain's master plan of drawing money across the ocean to London didn't exactly work; people who managed to pull money out of the market used it to keep their own assets above water instead of investing it in the cherry pickings of the British bank rate. The result of this is that the rate was repeatedly cut throughout 1930 and 1931 in order to encourage loan buyers rather than large scale investors.

Third, Britain defaulted on their gold payments from World War I debts in 1931. With this dropping rate, many people simply took their gold out of Britain, sapping the national bank dry of gold. Without this resource, the bank simply could not make payments.

Fourth, the United States saw a banking disaster in 1932 and 1933. With Great Britain abandoning the gold standard because they didn't have enough gold to cover the problem, people turned to the United States, which was still using the gold standard and was the only large economy still willing to exchange cash for gold. Every economic entity in the world proceeded to withdraw their money in the form of gold from the United States before the United States left the standard. This act bankrupted countless banks in the country and hardened the already-forming Depression.

The end result? A second world war, the institution of sharp caps on interest rate changes in most nations, and a swing towards state-controlled economies in the aftermath of this great failure of laissez-faire.

The Recommendations

So, what can we do to prevent such a global economic disaster in the future? Here are some recommendations; as a citizen, you should make sure that the candidates you vote for are thoughtful about these issues.

1. Be very wary of joining free trade agreements and organizations, like NAFTA or the WTO. Such systems result in the interdependency of economies on each other. If each economy isn't protected, then a disaster in one can drag down others. Essentially, it creates a financial net like the one described above.

2. Restrict direct investment of one nation into international stocks. When the wheels fell off of the New York Stock Exchange, not only did it damage the United States economy, but it took down the economies of most of western Europe right along with it. The economic damage of the stock pyramid scheme would have been limited to the United States (largely) had other nations not been players in the mess.

3. Diversify, diversify, diversify. Having all of one's investments in one type of investment is asking for disaster, and this is true for both individuals and larger groups. Invest in bonds, CDs, and other such investment avenues; don't put everything you have into stocks.

4. If everyone is investing in the same thing, do not put your money there. This simple mistake causes giant bubbles like we saw in 1929 (and 2000s dot bomb was all just a little bit of history repeating). People are like sheep, investing their money into the same thing as everyone else. Avoiding this, and putting your money into CDs when everyone is buying tech stocks for example, is just sensible economics.